"from henceforth none be so hardy to tell or publish any false News or Tales, whereby discord, or occasion of discord or slander may grow between the King and his People, or the Great Men of the Realm."

Definitions over, we are back to the substance of the theory. Keynes lets us know that he intends to focus on the aggregate demand function as the unfamiliar element in his theory: we won’t return to aggregate supply until Chapter 20. For the next three chapters we will be looking at the consumption element of aggregate demand, before turning to investment.

The basic consumption equation (Keynes gives it in terms of wage units and in nominal terms) is: Consumption depends in some way on aggregate income. More strictly, it depends on employment, but Keynes explicitly assumes that a given level of employment generates a given level of aggregate income.

He breaks down the ways in which consumption depends on income into three moments: (i) on the quantity of income; (ii) on other objective circumstances; and (iii) on subjective psychological propensities and the distribution of income between types of individuals. In this chapter he focuses on the objective factors, running through six of them.

(1) A change in the wage-unit. That is, the money value of the wage unit, i.e., when wages and prices rise or fall together. Keynes argues that the consumption function is mainly in real terms, not money terms, but when this kind of change happens there will be some redistribution of income between those whose incomes move with the price level (workers and entrepreneurs) and those whose incomes do not. Note that because Keynes believes that the real wage equals the marginal product of labour, there is no consideration of the case where prices and wages move apart.

(2) A change in the difference between income and net income. Usually these will rise and fall together, but if the gap widens or narrows, it’s net income that really counts in determining consumption.

(3) Windfall changes in capital-values not allowed for in calculating net income. This is the wealth effect we hear so much about these days. The value of shares, houses, capital goods or whatever increases (or falls) and wealth-owners decide they can afford to spend more out of their current income. These windfalls are important because “they will bear no stable or regular relationship to the amount of income.” [p. 92]

(4) Changes in the rate of time-discounting, i.e. in the ratio of exchange between present goods and future goods. This is more-or-less measured by the rate of interest, but also incorporates anticipated changes in the value of money, the possibility of dying before being able to enjoy expenditure out of savings, etc. According to Keynes, the effects of these changes are complex, and this is a big point of difference between him and ‘the classicals’, who thought the interest rate was the mechanism bringing equilibrium between savings and investment.

It has long been recognised, however, that the total effect of changes in the rate of interest on the readiness to spend on present consumption is complex and uncertain, being dependent on conflicting tendencies, since some of the subjective motives towards saving will be more easily satisfied if the rate of interest rises, whilst others will be weakened. Over a long period substantial changes in the rate of interest probably tend to modify social habits considerably, thus affecting the subjective propensity to spend – though in which direction it would be hard to say, in the light of actual experience. The usual type of short-period fluctuation in the rate of interest is not likely, however, to have much direct influence on spending either way. [p. 93]

Not many people will change their saving habits over an interest-rate change of one percentage point, quite large in macroeconomic terms, though they may change how they save. Keynes argues that the biggest impact of interest rate changes on consumption come through the capital gains and losses they instigate, and these are dealt with under (3).

(5) Changes in fiscal policy. This is pretty obvious – government surpluses reduce and deficits increase consumption. Actually, it is the movement between them that matters. Keynes also points out that redistributive tax policies (from rich to poor) increase the propensity to consume because the poorer consumer more of their incomes.

(6) Changes in expectations of the relation between the present and the future level of income. Keynes includes this “for the sake of formal completeness” [p. 95] but doesn’t think it very important.

Having catalogued these, Keynes concludes that none of them will affect the propensity to consume very much, with the partial exceptions of the wealth effect, and fiscal and monetary policy. Therefore, consumption depends mostly on the level of income (which is closely tied to the level of employment).

This part is familiar to anyone who has been taught anything about Keynes: consumption will rise with income, but not by as much as income. If income falls, consumption will fall, but not by the same amount. This is partly because in the short-run people do not change their expenditure patterns much even if their income changes, and partly because as income rises, people tend to spend a smaller proportion and save a larger proportion.

The next section is a digression on the effect of depreciation on consumption and investment. The basic point is that an allowance for depreciation beyond what is actually spent in the current period on maintenance, etc., is effectively saving. If we assume that each year a constant proportion of these depreciation funds are spent on replacement equipment, we can ignore it, but in the actual economy, the replacements tend to happen in waves with the business cycle. This seems like an obvious point, but Keynes spends several pages on it. Maybe he is trying to emphasise that firms save too, since we tend to think of saving as something households do – though, in fact, he treats it as a deduction from income rather than saving as such.

He argues that depreciation funds can be good practice for individual firms while being macroeconomically perverse. For example, after the wave of investment in the last half of the 1920s in the United States, firms were paying large amounts into these funds on behalf of capital that did not need replacement. “This factor alone was probably sufficient to cause a slump.” [p. 100] And to prevent recovery too. In the UK, local governments were maintaining large sinking funds for their investments in housing, and aggravating unemployment.

The last few pages on this point, though, are a great read. Keynes is still talking about depreciation funds, but this is just as relevant to, say, superannuation funds:

We cannot, as a community, provide for future consumption by financial expedients but only by current physical output. In so far as our social and business organisation separates financial provision for the future from physical provision for the future so that efforts to secure the former do not necessarily carry the latter with them, financial prudence will be liable to diminish aggregate demand and thus impair well-being, as there are many examples to testify. [pp. 104-05]

Though in the case of superannuation funds today the issue is the opposite of what Keynes was worried about – the drain from current expenditure. With super funds the problem is that the funds in themselves don’t guarantee any extra output in the economy at the time in which they will be drawn upon. Underproduction rather than underconsumption. The point is excellently made (from a Marxian perspective) here: “Superannuation: The Ricardian crisis” by Dick Bryan

And on the importance of consumption growth for overall growth (while the (neo)classicals usually emphasise the saving):

Thus the problem of providing that new capital-investment shall always outrun capital-disinvestment sufficiently to fill the gap between net income and consumption, presents a problem which is increasingly difficult as capital increases. New capital-investment can only take place in excess of current capital-disinvestment if future expenditure on consumption is expected to increase. Each time we secure to-day’s equilibrium by increased investment we are aggravating the difficulty of securing equilibrium to-morrow. [p. 105]

This is the kind of thing that gets Keynes labeled an ‘underconsumptionist’, which is an insult equivalent to ‘conspiracy theorist’ in the world of economics. It strikes a strange note to read this stuff today, when fighting inflation (and thus keeping a lid on consumption) is the first priority of macroeconomic growth. Part of the argument of my PhD thesis is that in the postwar period macroeconomic policy became a ‘Keynesianism of restraint’ well before the monetarist counter-revolution. Keynes’ macroeconomic perspective was retained, but policy was directed to holding back wages and consumption on the grounds that it was inflationary in full-employment conditions. As early as the 1950s it began to be realised that ‘full employment’ (in the old-fashioned sense that everyone who wants a job can get one) was incompatible with such restraint. But ‘full employment’ was politically popular, so for a couple of decades ‘full employment’ and ‘price stability’ fought it out. Then came the 1970s.